Tesco and Booker – The Great British Food Merger?

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I was just leaving the room on Friday, when I thought I heard on the radio that Tesco was merging with Booker. I smiled as I’d clearly misheard. When I realised it was true, my mind drifted back to the past.

The UK grocery chain, Safeway, used to own both a cash & carry and a delivered wholesale chain. I was a non-executive director of both these, as well as finance director at Safeway itself. So I have direct experience of managing both wholesale and retail in one group. This made me a bit surprised that Tesco is so keen to try the same thing.

What does it tell us about Tesco?

Tesco has struggled with both accounting scandals and weak grocery sales growth in recent years. The former revealed a poor culture in the business, but the latter will have been the more significant issue weighing with the board. Grocery has become more centred on internet/home delivery and convenience stores. The former is lower margin, as customers are not prepared to pay the full picking and delivery costs. Convenience stores are less profitable as they have higher costs than larger stores. Meanwhile the grocery market has been stagnating, not helped by low sales inflation.

Supermarket non-food has not produced much growth in the economic downturn and is also affected by the growth in online retailing. So Tesco has been in search of growth from somewhere outside grocery retailing.

The fact that Tesco has not bought a general retailer tells us that it doesn’t have much faith in non-food retailing for growth. As with its own non-food offering, general retailing has been struggling. The obvious partner for Tesco, M&S, was probably considered too expensive and too difficult. Sainsbury has already secured the leading bricks/online combo retailer, Argos.

Tesco has been eyeing the catering market for some time as a growth opportunity. It took however a misstep by buying Giraffe and Harris + Hoole – too small and with too much complexity to move the needle.

This also tells us that the strategy to grow Tesco internationally is being put more on the back burner. After the expensive debacle of launching in the US, Tesco feels suitably cautious.

Tesco now is trying to buy a cash and carry and delivered wholesale business. This will bring it exposure to catering (£1.9bn Booker revenue and growing) as well as small grocery retail supply (£3.1bn and flat).

Is it a merger or take-over?

This is a takeover in all but name. Tesco is paying a 15% (24% on a 3 month average basis) premium, and only the talented Charles Wilson, CEO, and the Stewart Gilliland, Chairman, are joining the Tesco board, in neither case as CEO or Chairman. Booker will contribute 14% operating profit in return for 16% of the equity. The premium however looks a little low for a takeover, which would usually be 30-40%. This tells you that Booker is pretty keen for this to happen, possibly an indication of their own concerns about future growth.

Has anyone else tried running retail & wholesale food?

Tesco may have been inspired by Germany’s Metro Group, that does indeed include a cash & carry and a hypermarket business, Real. However the performance of the Real hypermarkets has been disappointing and Metro sold the Eastern European Real businesses in 2012. There appear to be few synergies between the cash & carry and retail businesses.

The Big Food Group, a merger of Iceland Frozen Foods and Booker, lasted only five years.

Will the merger actually happen?

It looks as if the main block will be the competition authority (CMA). Tesco will explain to them that the only overlap is on retail, as catering is a different market. The CMA will look at the degree to which Tesco will use its ownership of Booker to influence small retailers. Small convenience stores will protest about this, and Tesco will almost certainly have to offer pledges that it will behave itself and not try to influence retail prices. Suppliers would do well to protest, not least as the largest element of the synergies is from ‘procurement’ ie squeezing them. The CMA will need to look hard at the prospect of Tesco getting access to wholesale cost prices. The investigation is likely to look at the market for convenience stores, although this could be broadened out to all grocery retailing, and the market for grocery supplies. This could take a year, potentially even longer, delaying the deal considerably.

The end result of this takeover would undoubtedly be a significantly stronger grip by Tesco on the grocery market. Will the CMA approve it? Logically, it probably shouldn’t allow it, but my three years experience at Safeway spent dealing with the Competition authorities is that bare logic is rarely the determining factor. I’d give this 50:50 at best.

What’s the benefit?

Take-overs are generally justified by synergies. In this case, they are a modest £200m pa after 3 years. It’s always good for an acquirer to focus on a Year 3 target, as after 3 years everyone has forgotten about the synergy target or dismisses it as irrelevant given all that has happened since.

Revenue synergies are given as £25m by year 3. At a marginal profit margin of say 20%, this implies additional revenue of £125m. With a current sales level of £60bn, that’s an uplift of 0.2% after 3 years. Blink and you’ll miss it. This is clearly just a notional number, so they either can’t justify, or they don’t believe in, any significant revenue uplift.

The cost synergies of £175m are the heart of this deal. Given that Tesco seems to have been working on this deal since June, it is very noticeable how lacking in detail these synergies are:

Procurement: Over half the savings are from procurement. This means two things; comparing different cost prices and using the combined volume to demand new lower cost prices from suppliers. On the former, it has been a holy grail for retailers to get access to wholesale prices, and this would appear to offer wholesale prices to Tesco. However, in my personal experience, suppliers are very aware of this issue and have in the past refused to give wholesale prices to retailers. They monitor sales to wholesalers and will stop supply if they see demand suddenly increasing as deliveries are being shipped onward from wholesale to a large retailer.

Tesco talks about ‘full crop procurement’ as a key, if obscure, benefit, but this is likely to be a red herring. This will be about pressurising branded suppliers. Tesco undoubtedly wants very much to get access to Booker’s cost prices, and if it does, it probably will be able to use its huge muscle to exploit this information. On top of this, Tesco will almost certainly be successful in just using its bigger scale to get better deals from suppliers generally.

Other cost savings: £60m odd from logistics seems a lot, especially as no detail is given. However, joint logistics costs are probably around £1.8bn, so this would represent a saving of some 3%, which is frankly not very much synergy! About £17m from other costs is also barely a rounding error, maybe 1.5% of other costs. The big issue will be whether they close the Booker head office and merge all the support functions.

What are the risks?

  1. Distraction: Booker will be the new shiny toy that all Tesco managers will want to play with. It will be very difficult keeping focus on the Tesco brand, only slowly now recovering, when there will be so much focus on another business, the integration and inevitable redundancies.
  2. Cost drift: This is a key reason that supermarket operators don’t run discount chains or cash & carries. When Safeway owned the discount chain, Lo-Cost, the moment anyone from the supermarket business got anywhere near the discount chain, they wanted to add cost. A cash & carry business has to have a very lean cost structure, even more so than a discounter, so Tesco management will have to work very hard indeed not to avoid extra costs creeping into Booker.
  3. Daddy knows best”. The acquirer’s management always tend to think that they are cleverer and more gifted than the acquiree’s. Functions move to the acquirer business and redundancies are concentrated in the acquiree business. This has already happened in the “merger” of the two boards, with only two Booker men surviving.
  4. Retailers think they understand cash & carry and catering. Charles Wilson will have his work cut out keeping Tesco management away from a very different business, of which they know next to nothing.
  5. Internal focus. It is inevitable that on a merger, focus tends to turn inwards as integration teams drive out synergies and managers jockey for position. It would be challenging for the combined group to keep developing the customer offering of both businesses over the next few years.
  6. Not understanding the risks at the start. It would have been more reassuring for the launch presentation to have at least mentioned possible risks!

Conclusion – is this a marriage made in heaven?

We are likely to have a competition inquiry that will last a year before we know if it will happen. If it gets approved, the businesses will then spend a couple of years integrating and settling down. If in this period, Tesco starts to lose out to grocery rivals in its core chain, then the synergies could easily be lost in weaker like-for-like sales growth.

Retail take-overs, as in other sectors, have a very mixed record. Iceland/Booker failed and was unwound. When Morrisons bought Safeway and merged two grocery retail chains, it decimated the combined profits of over £600m operating profit (excluding any synergies). Today Morrisons still only makes just over £300m, half that of the different businesses 13 years ago. A failed takeover generally proves very expensive.

On a £20bn joint market capitalisation, the synergies would be worth some £1.6bn (less tax, using a 10x multiplier), so this is an 8% opportunity. This is pretty much the uplift in Tesco’s share price after the announcement this week.

I suspect that the synergies are well grounded and sufficiently discounted that the target £200m in 3 years will be delivered. However investors need to consider four other questions;

  1. Will it get competition approval?
  2. Will Booker accelerate Tesco’s medium term revenue growth, especially in catering?
  3. Will combining wholesale and retail be disruptive to the two businesses?
  4. Will management distraction damage core performance of either business?

Overall the deal gives immediate one-off consolidation growth to Tesco, justified by cost synergies. But it also raises major risks in competition clearance and execution. This doesn’t feel like a marriage made in heaven, but very much made of convenience.

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7 thoughts on “Tesco and Booker – The Great British Food Merger?

  1. armchair

    Simon,

    Thanks, a very interesting, informed and informative analysis. A question if I may please.

    Can it really be the case that Booker pays ‘wholesale prices’ to suppliers that are lower than those paid by Tesco? One had assumed that the buying synergies flowed in the other direction, with post-acquisition Booker able to buy much cheaper, as able to leverage Tesco’s vastly greater buying scale.

    I may have the numbers wrong, but in its review of the sector, the Competition Commission suggested that the supermarkets’ COGS were closely correlated with buying scale (if memory serves, think they said each additional £1bn in revs boosted gross margin by 60bps, or it may have been each additional £1bn of COGS). In any event, would be surprising if Booker bought cheaper than Tesco across many categories wouldn’t it? Or is the cost to serve much, much lower?

    Best,
    AC

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    1. armchair

      Have found the data, and CC in 2003 report suggested 30bps of improvement in buying terms for each additional £1bn in sales…

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    2. Simon Laffin Business Services Ltd Post author

      Only the suppliers will know if they have kept wholesale prices below retail, but I guess that means that ex-manufacturer Dave Lewis knows! Although greater scale will tend to give a buying benefit within a market, a cost price to a wholesaler needs to feed two margins (the wholesaler and the retailer) so there is a reason why a supplier would allow a lower cost price to a wholesaler than directly to a retailer. This has been a major issue, particularly with tobacco.

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  2. Mike Dennis

    Simon,
    I enjoyed reading your thoughts on the Tesco ‘merger’ with Booker and agree with a lot of your comments.
    On the flow of buying gains (wholesale/retail), I assumed that if Booker make a 2% GM (their guidance) on Tobacco COGS of £1.5bn and its franchisees make 11%+ GM (McColl’s shows a 11.7% margin on Tobacco with £250m of COGS) and Tesco makes 7% GM (range i believe is 5.5% Extra to 10.5% at Express) on £1bn of Tobacco COGS then I assume Tesco will seek to recover (demand !) the 2% + 4% diff on their COGS equal to 6% of £1bn or £60m. This maybe lower depending on the margin mix at Londis, Budgens but I assume that is what you mean by wholesale prices below below retail. Is that a logical explanation ?
    MD
    PS hope you are well, I am sure Tesco has more plans for other ‘growth’ channels and agree that Tesco has a poor track record for over paying for its ‘toys’ and then breaking them !

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    1. Simon Laffin Business Services Ltd Post author

      Mike,
      Thanks. Yes, your analysis looks sensible to me. In essence a tobacco manufacturer has to allow both the wholesaler and independent retailer enough margin for both to survive and want to sell tobacco. This requires a bigger margin than a grocery major needs alone. The manufacturer will therefore try to maintain a lower price for wholesale supply than for direct retail. Provided all tobacco retailers hold this line, and stop retailers diverting wholesale to retail, and keep tobacco smuggling under control, this differential pricing can survive.
      Simon

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      1. armchair

        Simon,
        Many thanks for your earlier reply. Do you think this is unique to tobacco or is it likely that Booker (with c. £5bn of sales) buys better than Tesco (£36bn of ex-petrol UK sales) in some other categories?
        Best,
        AC

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  3. Simon Laffin Business Services Ltd Post author

    Mike, I doubt that it buys better in any particular category, but it will have better deals with certain suppliers/products, often just for historical reasons. However negotiating the same wholesale to retail prices is a major issue. I would expect Tesco to focus hard initially on getting overriders for both wholesale and retail volume, which would be easier.

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